In early 2008, I was convinced that the U.S. dollar would rally, even though it was universally hated at the time. The chart looked sold out, and it appeared to me as though the dollar was being quietly accumulated. Additionally, I remember saying that I expected inflation fears would lead to higher rates, which would catch the dollar shorts flat.

As it happened, I was dead-right on the move higher in the dollar … but dead-wrong as to why.

The catalyst ended up being a gigantic flight to quality, led by the total meltdown of global financial markets. In other words: right call, wrong reasons. I’ll take the “right call” every time, because the “why” of a move is far less important than actually participating in the move.

Very often, we may not know why a position is moving, but that’s where technical analysis[1] comes in. The price action will almost always lead the news/fundamental action.

With the dollar, I saw day after day of negative news stories and, yet, the dollar had stopped making new lows.

When in doubt, always defer to the price action above your opinion or anybody else’s.

U.S. Dollar Index

After trading as low as $74.23 on Dec. 1, 2009, a surprisingly good jobs report on Dec. 4 had the U.S. dollar on fire. Over a three-week period, we saw the U.S. Dollar Index (DXY) rally all the way back to $78 and change.

A 5.5% move might not seem like much but, in the currency markets, that’s bloody huge! Over-leveraged traders who stayed short the dollar through the December rally got their faces ripped off. Talk about “a day late and a dollar short” — literally!

What’s next for the DXY?

Well, once again it looks like an unexpected Friday jobs report is about to unmake all of December 2009’s gains. Last Friday’s highly disappointing numbers — along with St. Louis Fed President James Bullard’s comment that interest rates will remain “low for some time” — appear to be bringing back the U.S. dollar sellers.

If the index breaks below $75, it’s “hasta la vista” for the greenback. We will almost certainly make new lows.

This belief is being confirmed by the very bullish action taking place in gold, which is the other half of today’s two-pronged profit play.

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Gold

The day the greenback broke out (on the positive Dec. 4 jobs report), gold prices stared tumbling. On Dec. 4, gold fell $48.50 — that’s $4,850 per futures contract in losses! In just a few short days, gold fell from a high of $1,218.40 per troy ounce to a low of $1,075.80 on Dec. 22.

As gold bottomed on Dec. 22, guess which currency peaked on that very day?

Yes, the dollar — as represented by the U.S. Dollar Index — which peaked at $78.45 on Dec. 22 and has been falling since then.

Go Long Gold, Short the Dollar

For now, at least, we can say that the U.S. dollar and gold are trading in lockstep, in opposite directions. The key to this trade (going long gold and short the dollar) lies in Wall Street’s perception of when interest rates will start increasing again.

What if you’ve invested, or want to invest, the other way around?

If you are short the dollar and long gold, you should pray every day that the Democrats do something utterly asinine, such as enacting a brand-new wave of stimulus spending. You will make a killing. In other words, the short dollar and long gold trade is really a play on the economic stupidity of politicians.

Just remember if the job market surprises to the upside or the broad economy shows strong signs of growth, this trade will reverse itself. — i.e., the dollar will rally and gold will fall.

The Best Way to Play It

My personal preference is to play the U.S. Dollar Index and the gold market by directly trading U.S. Dollar Index futures and gold futures. However, I can appreciate that few people want to take the risks associated with direct trading in the futures market[2].

The good news is that you don’t have to. There are some terrific exchange-traded funds (ETFs) that you can use to play the dollar/gold relationship.

For gold exposure, you can buy the SPDR Gold Trust (GLD[3]). Each share gives you a representative ownership of 1/10 of one troy ounce of gold.

You can track the U.S. Dollar Index through ticker symbol DXY and can participate on the “short side” with the PowerShares DB U.S. Dollar Bearish Fund (UDN[4]).

UDN was designed to replicate the performance of being short the dollar against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. These are the six currencies that the dollar is measured against that make up the U.S. Dollar Index.

In conclusion, it looks as if December’s move in the dollar was just a bear market rally. If that’s true (and I think it is), then the U.S. dollar will make new lows. If the dollar makes new lows, then gold will trade much higher (along with many other commodities).

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